~ Investment Strategy

Morning Note: A great European mess

ND, PASOK and Democratic Left are to meet today. Last week they came up with a framework for a government that would last until 2014. The hurdle seems to be that all three insist on at least tacit support from Syriza, despite the fact that they would have a majority in parliament on their own. There are other possible ways that a government could be formed — after all, ND and PASOK are only two seats away from a majority. For example, some members of the Independent Greeks, an agglomeration of former ND members, could move over.

I have not seen any good analysis of why ND, PASOK and DL are not prepared to go it alone, but I assume it is because they think that their political fortunes would suffer if they had to endure constant sniping from Syriza. On the other had, the fact that Syriza is now riding high in the polls means that it is not in the interest of ND or PASOK to drive the country into another election. It therefore seems likely that they are engaging in brinkmanship in order to win the political cover of a unity government, but that behind the scenes they will be doing everything they can to avoid another election. This does not mean that another election will necessarily be avoided — brinkmanship is dangerous — but it means that it is relatively unlikely.

At the same time, the question of Greek exit from the euro seems to be on the agenda, thanks to several central bankers. The Governor of Belgium’s central bank said that an “amicable divorce” was possible, the Governor of the Bank of Ireland said that Greek exit from the euro could be managed from a technical point of view, and Jens Weidmann of the Bundesbank said that the consequences of Greek exit would be considerably worse for Greece than for the rest of the Eurozone. Why are central bankers suddenly talking about something that is not actually on the table in Greece (according to polls, 78% of Greeks want politicians to do everything possible to keep the country in the euro)? Again, I am in the realm of assumption, but it seems reasonable to think that, as usual, European policymakers are making pronouncements for each other’s consumption (a feature of European politics that never ceases to confuse the markets). Central bankers do not want Greece to default on the bonds held by the Eurosystem or on their debts to the European bailout institutions and, by linking default with euro exit, are trying to pressurise Greece’s politicians into forming a government that is supportive of the latest bailout

Paul Krugman has said that Greece’s exit from the euro could come as early as next month. But how? Without a government, there is nobody to take the political decision to leave the euro. If Greece does form a government, the continued public commitment to the euro ought to keep it from deciding to leave. The only series of events that I can see that would lead to an exit from the euro in the near term is a complete collapse of confidence in the economy such that the entire Greek citizenry attempted to move its euros abroad. In that situation, Greece’s banks would already have been destroyed and any government that was subsequently formed would find that many of the bad consequences of euro exit had already taken place — greatly reducing the future cost of a decision to leave. That does not seem to be happening at present. All the negative headlines about Greece are presently about its attempts to form a government.

If a government is formed and it is committed to the bailout, then austerity will continue to depress the Greek economy and the deficit may well not stabilise as a percentage of GDP (because, as I have been arguing for some time, austerity is contractionary and the contractionary effect my offset the effect of deficit cuts). Greece’s debt level is still much too high. I do not disagree that there will have to be some kind of reckoning; but I do not see why the present political wrangling makes it inevitable today.

What is going to happen in Spain?

The latest run-up in Spanish yields was caused by the previous government’s having missed its deficit target last year, and a growing fear that the present government will miss its targets this year and next, in spite of the fact that this year’s has already been revised to make it easier to hit. There is talk of the EU giving Spain an extra year to hit the maximum 3% deficit/GDP ratio laid out in the new fiscal treaty. And as Spain’s economy deteriorates, fears grow for its zombie banks, which are sitting on billions of euros of unrecognised property losses. At the same time, the government appears to be committed to dealing with the deficit; it is starting to rein in the regions; it is seemingly becoming clear to the market that excessive austerity depresses an economy to the extent that it can become self-defeating; the new government is proactively trying to clean up the banks; and the debt/GDP ratio remains manageable. Because of these positive factors, it would seem surprising if the negative factors were enough to spark a run on Spanish bonds — and even if they were, the ECB is ever lurking in the background, ready to lumber into action and buy Spanish bonds if things deteriorate. This has been the basis of my recent trading: markets have sold off on Spain, but Spain should not become a full-blown crisis, so market should recover.

One possible crack in this edifice of thought is the fact that the ESM can lend only to governments. It could lend to Spain for the purpose of bank recapitalisation, but that would increase Spain’s government debt. The Bank of Spain estimated the level of banks’ “problematic” loans at EUR 184bn last year, which is around 18% of Spain’s GDP; that would be quite a jump in government debt, although even then, debt/GDP ought to stabilise below the 120% level that European politicians seem to consider “sustainable.” This problem could perhaps be mitigated if the ESM were allowed to recapitalise the Spanish banks directly. But that is not possible at present, and the market is worried about the possible need for a bailout.

Have I become too complacent?

I have long argued that the situation in Europe is unsustainable and that such measures as higher inflation in Germany or permanent fiscal transfers would be necessary to end the crisis. But after the ECB’s 3-year LTRO’s were announced, I thought that the crisis was over for Italy and Spain, unless and until their solvency came into question. This was because I saw the LTRO’s as implying that the ECB would fund those countries balance-of-payments deficits indefinitely and would prevent any significant European bank from collapsing. It is consistent with this framework to observe that Spain’s solvency has come into question in a sense, in that the markets have been questioning the country’s ability to deal with its banks. This is the reason why questions over its solvency have arisen earlier than I had expected (and why Italy is not in the headlines — it does not have the same problem). I have to admit that I missed this storm as it started to brew. But I do think that the problem is Spain’s banks is manageable, and that the solutions are easy to imagine. It ought to be possible to deal with them without a new European treaty, using the institutions that have already been set up. Thus I still do not expect the current storm to develop into another serious crisis episode.

What if markets are losing faith in austerity?

The great danger to this sanguine view is that the markets have, at last, lost faith in austerity. That would be a good thing from the point of view of Europe’s people — after all, austerity was never going to work — but it would mean that the solvency of the countries undergoing austerity programmes could come into question precisely because the market believed that those programmes were excessively damaging. Such a change could reopen the European crisis and require that governments tortuously hammer out an entirely new approach to the crisis. While the did this, markets would probably have a serious panic.

Clearly this is happening to some extent. But how far? I have not thought my way through this yet.

Also, what will the ECB do next? What is the threshold for further action?

Data

Preliminary Michigan sentiment 77.8 b.e. and rose to a new post-crisis high.